NBER Working Paper No. 2069Issued in December 1986NBER Program(s):Public Economics

The Economic Recovery Tax Act of 1981 mandated a series of tax rate reductions for the period 1982-1984. They represented the most significant changes in the tax rate structure in nearly two decades. This paper considers the response of taxpayers to these cuts and extends these results to estimate the revenue maximizing top tax rate for the personal income tax The methodological emphasis of this paper is to create a baseline income distribution to describe what level and distribution of income could be expected in the absence of tax changes. This baseline is then compared with actual tax return data to measure the change in taxpayer behavior. Throughout this study the National Bureau of Economic Research's TAXSIM model was used to perform the detailed microsimulation work. This paper finds that at least one sixth, and probably one quarter, of the revenue loss ascribable to the 1981 tax law changes was recouped by changes in taxpayer behavior over the period 1982-1984. It concludes that under the tax base of that period, federal income tax revenue would be maximized at a tax rate of about 35 percent, and total income tax revenue maximized at a total tax rate of 40 percent. The findings also suggest that personal income averaged as much as 2 percent higher than it otherwise would have been as a result of the behavioral response of taxpayers to lower tax rates.